Taking a bearish view of the US housing market should be a no-brainer. There is sharply declining house price appreciation across all local housing markets and housing indicators such as starts, sales and mortgage applications are all showing declining trends. But try telling that to a CDO manager. These vehicles have been buying so much triple-B home equity loan (HEL) paper that they now account for 80% to 90% of all buyers at this level.
This bullish demand is such that CDOs are now threatening serious disruption to the fundamentals of the HEL market: it doesn’t matter how bad the figures get, there is just one continuous long from CDOs. And it is not as if you can’t express a view. The development of ABS CDS last year was seized upon by macro funds to do just that, and they bought protection on specific names in their droves.
CDO managers seem to be defying fundamentals (and distorting the market) by continuing to pile into subordinated HEL paper and causing spreads to continually grind in. In early May there were record volumes of ABS CDS, with numbers approaching $2.5 billion in one week. This activity is dominated by CDOs selling protection: recent figures from RBS estimate that volumes in triple-B and triple-B minus paper run at between $200 million and $1 billion per week.
The numbers of macro funds wanting to buy protection on triple-B HEL have simply been overwhelmed by the numbers of CDOs selling it: writing a naked short into the CDO bid for triple-B HEL has proved to be a very dangerous game. (Many funds have also been playing a capital structure arbitrage such as buying double-B cash and hedging with triple-B-minus CDS but this trade is also now evaporating). Some funds are now finding that (in the absence of any sustained spread widening) they cannot support the negative carry on their shorts indefinitely. These are expensive trades to carry (they can cost between 180bp and 200bp a year) and the funds might, therefore, start to unwind them.
The HEL ABS sector is just one where CDOs are making their presence felt. By surging into B and C loan syndication in the LBO market, CLOs have also distorted market dynamics there, and the result might be a change in the way these deals have traditionally been structured [see How CLO managers muscled in on the LBO market, this issue]. CDO liquidity now wields enormous influence across the market – ignore it at your peril.
